The land of the rising sun might better be described as the land of the false dawn from an investment perspective. Time and time again, investors have been seduced by the stock market’s apparent promise, only to find it's little more than hot air. We're heading there again - will it be different this time?
Some things certainly haven't changed. Growth is showing signs of slowing and deflation remains the order of the day. But valuations are very low compared to historic levels, and the Japanese government’s decision to intervene to weaken the currency – the first time such radical action has been taken in six years – and boost growth could be a catalyst for equity prices.
What went wrong?
Any assessment of Japan cannot give enough emphasis to its spectacular ability to disappoint investors. The country’s current problems started with the build up of massive asset bubbles in property and stocks. These burst at the end of the 1980s, and the ensuing crisis revealed a dysfunctional banking system, sorry corporate governance, and ineffective economic policy, all of which ultimately led to a protracted period of anaemic growth and deflation.
Other economies have surmounted bigger problems in much less time than the two decades that Japan has been in its funk. But they don't suffer from Japan's biggest problems: its people are just too old and too frugal. Japan’s aging population and low immigration puts the country at a huge demographic disadvantage, as an expanding population and healthy supply of young enthusiastic workers is vital fuel for economic growth. In 2005 the birth rate actually slipped below the death rate for the first time and the trend has continued since. In 2009 Japan had 8.5 babies per 1000 people compared with 9.1 deaths. That compares to 28.1 per 1000 in 1950, according to the CIA World Factbook.
"Japan is not going to generate growth internally because the population is declining," says Tony Roberts co-manager of the Invesco Perpetual Japan unit trust. "It’s not supply of funds that’s the issue with Japan, its demand for funds."
And then there is all that saving. Although the savings rate has come down in recent years, it is still at a level that would make most Americans and Brits wince. Even with zero interest rates, the prospect of buying something today that deflation could make cheaper tomorrow remains a powerful disincentive to spending. Meanwhile, the prospect of deflation pushing up the real burden of debt means corporations remain incentivised to pay off loans, rather than invest.
What’s New?
But could a reinvigorated, radical economic policy be about to lift Japan from the mire? It is by no means the first time the question has been asked, and the right answer so far has never been "yes". A power struggle in Japan’s ruling party has seen the incumbent leader, Naoto Kan, fend off the challenge of a more economically progressive opponent. While this news initially led to a fall in the stock market and a rise in the value of the yen, things soon changed. It seems the policies of currency intervention, fiscal stimulus and monetary loosening, which were associated with Mr Kan’s rival during the leadership battle, have rubbed off on him.
In mid-September Japan intervened in the currency market to sell yen for the first time in more than six years. An exchange rate of 82 yen to the dollar, which represented a 15-year high, was just too much for the export-dependent economy to bear. Interest rates cuts and money printing has followed in a concerted effort to stimulate the economy and fend off of a slow down.
Japan has had fiscal and monetary stimulus in spades before, of course - one reason why, in addition to its lousy demographics, it has debt that's roughly twice economic output (GDP). Nor do Japanese politicians do not have a very inspiring record when it comes to economic policy. "Politics has long been a negative for the Japanese markets," says Gavin Haynes of IFA Whitechurch Securities. "Any significant evidence of [economic policy succeeding] is still to emerge."
All in the price?
However, Japan bulls argue that the Japanese stock market has one major thing going for it that it has not been the case previously: valuation. By historic standards shares, look cheap on a number of measures. First of all, the market as a whole is valued at the aggregate net value of corporate assets - or book value in the jargon. Our graph chronicles the 20-year decline that has taken valuations to this level, although it still doesn’t capture the height of late 80s valuations at about five times book value.
"We’re pretty bullish at the moment and the main difference is valuation," says Invesco’s Mr Roberts. "When the market is valued at or less than book value, you’re effectively saying companies in Japan are never going to add value again… Japan will remain a cyclical economy, but because of valuation it will no longer be in this structural down trend."
In addition, the yield on the Nikkei 225 of 2.2 per cent also looks attractive. It's more than that boasted by the S&P 500 and more than twice the yield on 10-year Japanese government bonds. Valuations based on earnings multiples do not stand out, but they never have - and there are hopes that a sustained global recovery could lead to upgrades from current depressed levels.
The world, and especially Japan's Asian neighbours, will need to avoid a renewed slump for the bullish scenario to play out, and on this front economic data is still proving encouraging, even if investors continue to fret. The value of the yen may also prove to be key in deciding whether the apparent value on offer results in share price rises. Traditionally the Japanese stock market has a strong inverse correlation with the yen: when the yen goes up in value (signified in our graph by a fall in the number of yen a dollar would buy), stocks go down and vice versa.
So a successful policy of controlling the yen can be expected to be beneficial to the index and in particular the share prices of exporters. Increased exports are one of the few things likely to kick start the domestic economy, and therefore share prices and valuations of domestic plays.
How to play the Japan story?
Whether you're hoping to ride a rally or want to buy in for the long term, here are some interesting ways to get exposure to the market through Japanese equity funds:
The currency play: Neptune Japan Opportunties
This open-ended fund offers bullish investors a way to bet both on the depreciation of the yen and a rise in the market. The fund has hedged the portfolio against the yen’s fall and following news of the government’s intervention after the currency hit a 15-year high against the dollar, this looks an enticing bet. “Recent yen highs look significantly overdone given the perilous state of the economy,” says Whitechurch Securities’ Mr Haynes.
The equity portfolio also continues the weakening-yen theme as it is focused on exporters. Exporters benefit from any fall in the yen because it makes their goods cheaper for overseas buyers. What’s more, among Japan’s exporters are many world-leading companies. The positioning of the portfolio does mean a global downturn would hurt, but if you’re bullish, you won’t expect this anyway.
The income Play: Jupiter Japan Income
While Japan does not have a reputation as a high-yielding market, and the Jupiter Japan Income fund itself only yields 2 per cent, there is a strong dividend growth story which underpins the fund’s investment mandate. Harsh economic conditions have forced a change in Japan’s corporate culture, which has seen large companies become far more responsive to shareholder demands.
Part of this restructuring process has been an increased focus on the dividend. Indeed, about 70 per cent of Japanese companies now pay a higher dividend than the 10-year Japanese government bond yield. Not only is dividend growth being driven by a change in corporate culture, the global recovery is also increasing payouts. The recovery of margins and cashflows in corporate Japan has been very impressive, which should feed thought to improved payouts.
As well as equities the Jupiter Japan Income fund can also invest in convertible bonds.
The bullish Play: Baillie Gifford Japan investment trust:
Investment trusts are always great vehicles for bullish investors. These closed-end funds have two advantages over open-ended vehicles when markets are rising. Firstly, shares tend to move from trading at a wide discount compared with net asset value (NAV) to a narrower discount or even a premium as markets improve and an investment story becomes more widely supported. The Baillie Gifford Japan trust offers plenty of scope for upside on this front with a discount of 15.4 per cent. The other great advantage investment trust have during bull markets is that they have the option to boost performance by borrowing money to buy stocks. But be warned, both factors also tend to increase the pain when markets fall.
The trust itself is hoping to benefit from the influence Asian demand will have on exporters and the potential for stimulus to reinvigorate domestic demand. The trust focuses on small-to-medium-sized companies, which marks it out from the crowd. It’s NAV performance over the last year is fourth best out of ten Japan trusts – including six small cap specialists – and it is number one over three and five years.
The passive plays: Japan trackers and ETFs
Even if you've long given up on Japan's structural recovery, don't write the stock market off. Japan's dependency on exports means the market is inherently cyclical, and it has routinely staged impressive rallies of 60 to 70 per cent during the longer-term decline. Given that it is currently flirting with lows for the year, this could be a base from which it will bounce even if the trajectory reverses again later. If you're content just to try and catch some of those rallies in the Nikkei, there are several passive fund offerings available. HSBC and Legal & General both offer index-tracking unit trusts, while all the major exchange-traded fund (ETF) providers offer products based on any of several Japanese indices. Note that the Nikkei 225 index is price-weighted, like the Dow Jones Industrials and the FT30. The Topix index series is capitalisation-weighted, like the FTSE100 or the S&P500, and adjusted to take account of free floats, thus stripping out the effect of corporate Japan's many cross-shareholdings.
